The traditional IRA allows you the opportunity to claim a tax deduction on your income tax return for contributions made to the IRA, and you must pay income tax on withdrawals from the IRA. The Roth IRA does not allow you to claim a tax deduction for contributions made to the IRA, but it allows you to withdraw money from the IRA, tax-free.
You are allowed to convert money in a traditional IRA to a Roth IRA to build tax-free assets. The question becomes, “When should I convert some or all of my traditional IRA assets to a Roth IRA?” A common thought regarding Roth IRA conversions seems to be to wait until retirement and then convert IRA assets to a Roth IRA, because income will be lower at that time and you will subsequently pay lower income taxes on the converted amount. In theory this may appear to be true; however, there are several common landmines that could make this timeline for conversion more expensive than what you might expect. Three such landmines are as follows:
- Social Security Benefits May Become Taxable—If your Modified Adjusted Gross Income (MAGI), including the Roth conversion, is above $32,000, and your filing status is Married/Filing Joint ($25,000 if filing Single), then 50% of your Social Security income would become taxable. If your MAGI is over $44,000, and your filing status is Married/Filing Joint ($34,000 Single), then 85% of your Social Security income would be taxable.
- Medicare Part B Premium May Increase—It takes 2 years for Social Security to catch up to your tax return when calculating your monthly Medicare Part B premium. For 2016, the normal Medicare Part B monthly premium is $121.80. If your MAGI for any year, including the Roth conversion year, is between $170,000 and $214,000, and your filing status is Married/Filing Joint (a MAGI between $85,000 and $107,000 if filing Single), then your 2016 Medicare Part B monthly premium increases to $170.50. Additional increases occur as your MAGI increases. If your filing status is Married/Filing Joint ($214,000 if filing Single), 2016 Medicare Part B monthly premiums top out at $389.80 when your MAGI reaches $428,000.
- Additional 3.8% Medicare Tax—If your MAGI, including the Roth conversion, exceeds $250,000, and your status is Married/Filing Joint ($200,000 if filing Single), your investment income—such as interest, dividends, rents, royalties, and capital gains—will have an additional 3.8% tax added on top of your current tax rate.
Although it is wise each year to consider opportunities to convert traditional IRAs to Roth IRAs, there is no simple answer to determine when a Roth conversion should occur and how much should be converted, because the tax laws have become so complicated. The solution is to consult a comprehensive personal financial advisor with extensive tax expertise prior to performing any Roth conversions. This will help you to determine the potential tax impact and to weigh the pros and cons of a conversion.